Wednesday, September 3, 2014

The best investors often look for network effect businesses - where each incremental addition of a user to the network increases the value of the network for the other users. These types of business are typically very defensible (hard to break the network) and quite valuable (if in a large market).

In Y-Combinator's case, the "user" in the network is a startup. YC creates a pretty amazing network effect for the companies who pass through. This includes:

1. Peer based help.
Many YC founders will ask other batchmates for their advice, feedback, and recent learnings. When I left Google to start my first company, there was similarly an invaluable network of ex-Google founders to tap into. This allows you to learn who the helpful investors are, tips on hiring, and about new types of distribution or platforms. These sorts of peer networks are invaluable and typically quite hard to come by quickly. YC plugs you directly into this network of peers.

2. Early advice and mentoring.
Beyond peers, YC provides a series of role models and mentors just a few years ahead of the current batch. YC founders can tap into founders at almost any stage of the startup lifecycle to get advice on what to expect next. This is where the true network effect of YC kicks in. By having more startups distributed throughout the lifecycle of a company, YC provides a broad based cross-mentoring network for all its companies. Each new company helps advise and mentor later companies.

3. Customers & market validation.
One of the most powerful aspects of YC is its built in customer development. Especially for B2B companies, YC provides an instant initial testing ground and potential user base for the startup's products. These early customer wins helps with both product testing and iteration, but also provides the startup with fast market validation. By having a number of early brand name customers (from prior YC batches) using the product, YC B2B companies can both get to revenue faster (helping with fundraising) as well as to some notion of product/market fit (due to fast and broad feedback).

4. Capital.
A number of YC founders have emerged as prominent angels. They can provide early capital and validation for a startup, allowing it to bootstrap a seed round more effectively. The first few dollars raised are always the hardest, so early investors are valuable in giving a seed round momentum.

Surprisingly, very few traditional venture firms have an ex-YC founder as a partner. I would expect this to change and to follow the pattern of Google, where VCs hired a number of ex-Googlers into their firms to access that talented network.

5. Branding.
Each new startup increases its chance of success by going through YC and being associated with past YC successes. The presence of AirBnB, DropBox and Stripe, as well as the next wave of YC startups (e.g. Optimizely, Zenefits, etc.) increase the chances of each incremental startup becoming more successful. The brand of the winners feeds back to increase the brand value of the newbies.

PS. 500Startups, AngelPad, and Lemnos Labs are all other examples of programs that exhibit aspects of the network effects mentioned above. Each program's network effects are modulated by its point of emphasis and focus (e.g. volume of startups, quality, specialization (e.g. hardware, international, etc.) stage and valuation of past participants, geographic location, etc.) E.g. I know a number of companies who mention the 500Startups email list of other founders to be incredibly useful. Similarly, with its emphasis on hardware Lemnos Labs startups can help each other with uniquely hardware-centric products. And AngelPad is currently NYC-based. A key consideration or lens to keep in mind when considering network effects is ultimately scale & quality of the users in the network.